The impact of bank competition on access to finance

Submitted by Maria Soledad Martinez Peria
On Mon, 08/20/2012

co-authors: Inessa Love

The impact of bank competition on financial markets and firms is an important topic of concern for policymakers and researchers alike. Interest in this topic intensified during the recent global financial crisis as researchers and policymakers questioned whether high competition was partly to blame.1Those against bank competition make two main arguments. First, competition may lead to risky lending practices as financial institutions search for higher margins. The increase in subprime lending is an example of such behavior prior to the recent crisis. Second, higher competition may erode banks’ profit margins and leave them with insufficient capital cushions, something that also played a role in the recent crisis. On the other hand, those in favor of competition argue that it can improve access to finance, especially for small and medium enterprises, and that any negative effects on stability are better addressed by proper regulation and supervision of financial institutions.

Whether bank competition does indeed improve firms’ access to finance is a much debated question in the economic literature and in policy circles. In a recent paper, Inessa Love and I combine multi-year firm-level surveys with country-level panel data on bank competition for 53 countries to offer new evidence on the link between competition and firms’ access to finance. In particular, our paper evaluates whether competition improves access to finance and analyzes the extent to which different features of the environment in which banks operate affect the link between competition and access.

Existing studies on the link between competition and financial access either analyze cross-sectional data or are only able to look at multi-year data for a single country. In contrast, our paper combines multi-year firm-level data with country-level panel data on bank competition. One advantage of our dataset is that it contains repeated cross-sections of firms for the countries in our sample. This allows us to control for unobserved differences between countries, using country fixed effects in our estimations. Such unobserved differences may be correlated with both access to finance and the extent of competition. Thus, our methodology isolates within-country variation in competition and access.

Furthermore, in contrast to studies that equate competition with concentration, we present results using the Lerner index, a direct measure of bank pricing behavior. Several studies have argued theoretically and empirically that pricing behavior measures such as the Lerner index are superior to concentration measures as indicators of competition.2 Concentration is a measure of market structure, while competition is a measure of market conduct. There can be competition in concentrated markets if there is a credible threat of entry and exit (i.e., if markets are contestable). A contribution of our paper is the ability to distinguish the impact of concentration and competition in a multi-country setting.

We find that low competition, as proxied by high levels of the Lerner index, is associated with diminished access to finance by firms, while concentration has a less robust relationship with access. We use different weighting schemes to account for differences in the number of firms across countries and the variance of the estimated Lerner index. Overall, our results support the market power hypothesis and are not consistent with the information hypothesis. Furthermore, our results confirm that concentration measures are not reliable predictors of firms’ access to finance, which is in line with previous contradictory evidence.

In addition, we explore whether the characteristics of the environment in which banks operate affect the impact of competition on access to finance. To do that, we interact our measures of competition with country-level measures of financial development, the availability of credit information, and government ownership of banks. We find that countries with higher levels of financial development and better information availability experience a less pronounced decline in access to finance as a result of low levels of competition (high values of the Lerner index). The flip side of this finding is that low competition is more detrimental for firms operating in countries with low levels of financial development or lacking credit information. In addition, we find that significant government ownership of banks exacerbates the damaging impact of low bank competition.

Overall, our results suggest that there are clear benefits to promoting bank competition. We leave for future research an analysis of the specific policies (e.g., adopting low barriers to bank entry and exit, fostering competitive pressures from non-bank competitors, facilitating access to credit information, implementing measures to ensure consumer protection, etc.) that regulators can implement to increase competition in the banking sector.